Your Triple Tax-Free Health Savings Account: Financial Planning MVP

“The most-favored investment vehicle under the tax code”… “the crown jewel of tax deferred accounts”… “the most tax-beneficial account on the planet”… those are the sorts of accolades health savings accounts (HSA) have been getting from financial experts. Just what’s won them so many raving fans?

In large part, it’s their unique triple tax-free nature that works in conjunction with other key features to make them a one-of-a-kind financial planning opportunity. “If you have the cash flow to make an HSA contribution AND cover out-of-pocket medical costs, it’s a home run,” says Rick Epple, CFP®, founder and president of Aurochs Financial Group in Wayzata, Minnesota.

All-Star Player

Just what makes the HSA the MVP of tax-advantaged accounts? It is the only triple tax-free savings option.

Tax Break #1: Tax-deductible contribution

Tax Break #2: Tax-free growth

Tax Break #3: Tax-free withdrawals for qualified expenses

Where others such as 401(k) and Roth IRA accounts offer tax breaks in two of the three possible ways, the HSA offers all three. But extra-special tax treatment is only one of several qualities that combine to make the HSA an all-star.

There are no income limits.

You don’t need to have earned income from employment.

Balance carries over from one year to the next.

Employers can also contribute.

You can take an employer-sponsored plan with you when you leave the company.

As a result, it lends itself to two usage models: short-term spending account and/or long-term investment account. Used the traditional way – as a short-term spending account – your HSA can go a long way toward easing the burden of the current year’s healthcare costs.

But if you are in a position to pay this year’s medical expenses from money outside the account, you can instead use your HSA to even greater effect as a long-term investment account. Those who take this approach can amass “a pot of money for when they’re older and medical expenses start to accelerate,” observes Aaron Rubin, CFP®, of Werba Rubin Wealth Management in San Jose, California.

Get in the Game

After an introduction like that, you’re probably ready to learn how you can use your HSA to hit it out of the park, financially speaking. But first, time out!

As discussed in this recent GuideVine article Health Insurance Decision Time Forces Big Questions, healthcare funding decisions need to be made in the context of your overall financial plan. Is one of the HSA-eligible health insurance plans available to you a good choice for you and your family? Does your cash flow permit you to make a contribution you can leave invested? Does an HSA fit with the rest of your savings and retirement plan?

If you can answer “yes” to these questions, then you are ready to step up to the plate.

Step 1: Vet or get the plan.

Not all HSAs are created equal, so you’ll want to scout around to make sure you have a winner. If you’re getting yours through your employer, be sure to thoroughly vet your options. If you’re on your own, check out HSA Search or Morningstar to find a plan that fits your needs. Either way, you’ll want to evaluate the investment options, expense ratios, fees, and plan features and constraints.

Step 2: Set aside cash for medical expenses.

Next, calculate how much you expect to pay out-of-pocket for the year’s medical expenses, and hold this money in an account outside your HSA. It should be held in a nice, stable savings account, not invested, since it is intended for very short term use. This should be above and beyond your emergency fund and any cash allocated for planned expenses such as a new car.

Step 3: Contribute.

Your next task is to figure out how much to contribute. Ideally, you’ll want to make the maximum contribution – $3,450 ($6,900 for families). For people age 55+ there is a $1,000 catch-up – assuming you have the cash and it is not earmarked for any other purpose.

Note to last minute filers: You have until April 17 to make an HSA contribution for 2017!

But use caution! If you tap the account to fix a hole in the roof or anything other than qualified medical expenses (per IRS definition), you’ll give up your tax deduction and, if under 65, pay a penalty.

If you’re not confident you can part with the cash, contribute less than the maximum amount, at least until closer to the tax deadline when you understand your financial situation for the year.

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Step 4: Invest.

Epple notes that, particularly with employer-sponsored plans, you may be subject to cash minimums, and fees may be auto-debited. That’s one good reason he believes “it might make sense to leave $3,000 or $4,000 in the account in cash.” Creating a safety net is another.

“Covering your deductible and maximum out-of-pocket should be a priority. Having a balance in your HSA after you’re done is a wonderful thing,” says Rubin. But if unexpected expenses force you to take an unplanned HSA withdrawal, “you can compound that pain by heavily investing in the market, and needing the money when the market is down.”

Still, if you are using your HSA as a long-term nest egg, you’ll want to keep the bulk of it invested. The contribution limits may seem low. But invested wisely – for your time horizon and your risk tolerance – the numbers can really add up over time. A client of Epple’s is a great example, having amassed a $75,000+ HSA balance by consistently making and investing the maximum family contribution.

Step 5: Reap the rewards.

It’s impossible to list all the ways your HSA can mitigate the effect of income taxes on your net worth. Starting with the obvious, a contribution to your health saving accounts lowers your current tax bill.

And according to Rubin, “The new tax law makes HSAs more important than ever because the ability to itemize health-related costs is decreased with the standard deduction going up. But this lets you create a medical deduction.”

Many – especially early retirees and others in low tax brackets – are doing Roth IRA conversions. A deductible HSA contribution can help take the sting out of that by offsetting the extra taxable income incurred as a result.

A healthy HSA balance can also be a godsend for retirees who experience an unexpected spike in medical expenses. Tapping HSA money to cover these costs could mean avoiding a taxable IRA distribution and possible jump to a higher tax bracket.

Play Ball!

No doubt, the HSA is the MVP of tax-advantaged accounts, a great all-arounder you’ll almost certainly want on your team. The rewards listed here are just the tip of the iceberg, but financial planning this sophisticated can be tricky business, not to mention highly individual.

With so many tax-advantaged accounts, tax law changes, and interdependencies in the tax code, you’d do well to consult your financial advisor or tax expert to make sure you’re getting the most out of your star player.

Sherrill St. Germain

Sherrill St. Germain, MBA, CFP®, is a freelance writer specializing in financial independence. A former fee-only planner, she brings a decade of financial planning experience to content she develops for financial professionals, publications, and her blog TheFISide.com
Follow Sherrill St. Germain on Twitter.

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